When exactly the Federal Reserve begins raising interest rates will unfold as a battle between monetary policy hawks and doves that will play out over the coming year or more. Inflation appears now to be the Fed's primary consideration, but how quickly the American economy reaches full employment will also be of significance. On inflation, monetary hawks want to stay ahead of rising prices for fear of losing control and having to raise interest rates even higher to regain price stability, while doves do not want to act until inflation is evident. On employment, the current focus for Fed hawks and doves is the labor force participation rate. Hawks believe the economy has fundamentally changed, that the downward trend in labor force participation since 2007 is structural and that frustrated long-term job seekers lack the needed skills. Doves believe roughly one third of the decline in the participation rate is cyclical, and that jobs will return as the economy heats up.
Looking at the economic data through that prism, the specifics of the March jobs report were certainly interesting. Beyond the unchanged 6.7 percent U.S. unemployment rate for March, the most important aspect of the report may have been the increasing labor force participation rate, which rose 0.2 percent to 63.2 percent. For doves, this was a small olive twig, a sign that the flood of unemployment is finally receding. Paradoxically, however, as more Americans return to seeking employment and as the work force grows, the more time it will take for the economy to reach full employment.
The Fed believes the natural rate of unemployment is somewhere around 5.5 percent and so an argument can be made that policymakers will not raise rates until we reach that level. Getting to an unemployment level of 5.5 percent is highly dependent on how many people are actively participating in the labor force. If the participation rate returns to its previous downward trend and job growth continues at about 200,000 jobs monthly, the unemployment rate would drop below 5.5 percent during the second quarter of 2015. However, if the participation rate increases by a single percentage point, full employment is unlikely to be reached until 2016.
The pattern of recent months of a rebounding participation rate will add weight to the dovish position if it persists. Whatever happens, investors would be well advised to keep an eagle eye on the participation rate.
The U.S. Participation Rate and Employment
The U.S. labor force participation rate hit a 36-year low in December, but since then has turned around, rising 0.4 percentage points, and is showing evidence of stabilization after a 3 percentage point decline over the last four years. Whether the recent increases are temporary or a sign of a broader trend are crucial for the outlook on monetary policy, since changes in participation have a large impact on unemployment. If the participation rate stabilizes or even rebounds, the pace of decline in the unemployment rate could slow, pushing back the date when the Federal Reserve begins to increase interest rates.
Unemployment Projections For Various U.S. Labor Force Participation Rates
Source: Haver Analytics, Bloomberg, Guggenheim Investments. Data as of 3/31/2014. *Note: In our flat participation rate scenario we assume the participation rate remains at 63.2 percent. The participation rate decline continues scenario assumes the participation rate falls by .025 percentage points per month. The participation rate rebounds scenario assumes the participation rate increases by .02 percentage points per month. We assume monthly employment gains of 200,000.
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